BAFI Research Seminar

Portfolio Spillovers and a Limit to Diversification

BAFI Research Seminarhttps://weatherhead.case.edu/events/2014/02/14/bafi-research-seminar

Firms are exposed to the idiosyncratic shocks to the returns of other firms. Looking at mutual fund portfolios and instrumenting to address flow / return endogeneity, I find that the shocks to other firms induce portfolio flows, which induce rebalancing and result in temporary price pressure on a given firm. A one standard deviation increase in the flow-induced price pressure corresponds to a .15-.6% increase in daily abnormal firm returns. This pressure fully reverses in 5-6 days, and the magnitude is larger if funds experience a net outflow than if they experience a net inflow. There is evidence that liquid firms are more sensitive than illiquid firms to this price pressure. These findings are consistent with the hypothesis that managers experiencing a portfolio return shock adjust the most liquid assets in expectation of fund flows. If investors are unable to properly estimate the correlations induced by being in common portfolios, they are unable to fully diversify away idiosyncratic risk.

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